Heavy debt burdens could adversely affect US growth next year

By
Richard A. Nenneman /
November 25, 1985

AT this time of the year, one begins to look more seriously at forecasts for the economy in the coming year. On the heels of an upward revision of the third-quarter GNP, to a growth rate of 4.3 percent, there are some forecasts that 1986 will be a stronger year than was expected earlier. Before considering '86, however, let's look once more at this question of the amount of debt in the economy and how that may affect growth next year. Last week the Federal Reserve Board released a letter which its chairman, Paul Volcker, had written to Sen. William Proxmire (D) of Wisconsin earlier in November. The letter showed the Fed's concern at the growth of all kinds of debt over the last four years.

The letter repeats the widespread nature and possible effects of the increase on both borrowers and lenders. Individuals and businesses are more vulnerable to economic downturn when they are heavily in debt. They are also more vulnerable to the increases in interest rates that generally precede the onset of recession. The federal government, by roughly doubling the national debt (with no end in sight to the annual deficits), has kept interest rates higher than they would have been without the government 's heavy borrowing. It has probably lowered future growth rates by ensuring that so much of the federal budget will go merely toward paying interest. And it has added to the amount of money that must be sent abroad each year to pay interest on the debt held by foreigners.

On the lending side, institutions holding the debt of more heavily leveraged individuals or corporations have to be concerned about its quality in the event of a recession. Although Mr. Volcker speaks with the deliberate caution of a central banker, he noted, ``I don't believe current trends are compatible over time with economic and financial stability.'' This concern expressed at the top of our financial structure is bound to be reflected in the policies of bank examiners and others who oversee our f inancial institutions and lead to more caution in the granting of credit.

The same theme was developed in this month's economic letter of CoreStates Financial economist A. Gilbert Heebner. He warns that both businesses and individuals are apt to draw back somewhat in the face of their heavy debt. This may be what happened in October, although one-month snapshots of activity need to be viewed against the preceding and succeeding snapshots as well. But in October, personal income rose 0.4 percent, while consumer spending dropped 0.9 percent -- the largest such drop in 25

years. This followed the consumer car-buying binge that occurred in August and September and may have been only a one-month phenomenon. It could also presage a more cautious mood going into 1986.

Mr. Heebner also notes that ``with borrowers' debt burdens growing, lenders may regard fewer borrowers as worthy to receive loans -- or may find fewer to whom they are willing to make loans at existing interest rates.''

He concludes, ``Economists have paid too little attention to debt in constructing their forecasts. The US and world economies are now confronted with widespread debt problems. These problems have the potential to keep growth below the current consensus forecast of about 3 percent over the next year, or even bring on a recession. The debt situation is worrisome in another respect. Policymakers here and abroad could eventually decide to relieve the pressure on debtors by turning to easy-money policies; th at is, they could try to inflate their way out of the problem.''